I worked in Japan for more than 12 years in the eighties and nineties, in Osaka, Nagoya and Tokyo with the U. S. State Department, Citibank and Merrill Lynch. After many more years in China in banking (Deutsche Bank and Ping An Bank) and consulting, I am back in Tokyo conducting the business of Yangtze Century Ltd. (Hong Kong/Shanghai) and producing this blog. E-mail me at smharnerco@yahoo.com.

Japan's Choice: Shrink the Welfare State or Collapse

Ruling Democratic Party of Japan (DPJ) Secretary General Katsuya Okada (4th R) joins ruling and opposition lawmakers as they bow their heads and pray in silence for the victims of a massive earthquake and tsunami one week after the disasters hit, at a meeting in Tokyo on March 18, 2011. The official number of dead and missing after the devastating earthquake and tsunami that flattened Japan's northeast coast a week ago has topped 16,600, with 6,405 confirmed dead, on March 18. (Image credit: AFP/Getty Images via @daylife)

Two months ago, following a year of fractious, hyperbolic debate, brinkmanship, and internal party revolt,

Japan’s political process delivered a 5 percentage points increase in national sales (“consumption”) tax, bringing the final rate to 10% by late 2015. Prime Minister Noda Yoshihiko had declared that he was “staking his political life” on achieving the tax increase, a measure his Democratic Party of Japan (DPJ) had opposed in its 2009 general election platform “manifesto.”

Noda, and the conservative Liberal Democratic Party (LDP) prime ministers up to the 2009 election, argued that, painful and unpopular as it is, the consumption tax is an indispensable source of revenue to support Japan’s social security system. This argument—indisputable as far as it goes—finally carried that day and garnered the needed votes. But it was a bloody, costly battle that no one now imagines can be fought again.

But the argument did not go far enough. In fact, it was so incomplete as to basically be a lie. The truth is, to support today’s system of old age social security and health care, the consumption tax must be more than trebled, to over 30%, and this must be done within the next five years, or the required tax rate will rise to close to 40%.

These figures are provided in an exceptionally clear and thoughtful analysis by Hitotsubashi University professor Oguro Kazumasa, published in the October 18 Nihon Keizai Shimbun.

Today, Japan’s old age social security system is running at a deficit, is the whole country. In my last post, I presented some of the warnings being voiced by the IMF at Japan’s fiscal improvidence. Professor Oguro adds:

The ratio of Japan’s debt to GDP is close to the peak suffered at the end of WWII, after which the country experienced high inflation.

While optimists note that foreigners hold only 7% of public debt, this is a stock concept. On a flow basis of new funding, foreigners are taking 30-50% of new debt issues, which greatly increases fiscal vulnerability to external shocks and loss of confidence.

Against this, costs of the social security system are now rising by over JPY 1 trillion (USD 12.6 billion). Over the next ten years costs will certainly rise over JPY 10 trillion.

With continually rising debt, interest costs—even at current super low rates–will swell from the current JPY 9 trillion (USD 114 billion) a year, to JPY 17 trillion (USD 215 billion). As a result, at the end of ten years, Japan’s annual fiscal deficit will rise from the current JPY 44 trillion (USD 560 billion) to over JPY 50 trillion (USD 633 billion).

The Japanese government Cabinet Office in August released a medium to long term forecast showing that in FY 2020 even after the 5% consumption tax increase combined national and local fiscal deficits will be some 3% of GDP (compared with 10% in 2012).

Previously, pledges to the G7 to achieve a balance on primary account (ex-interest expense) supposed a further 6% increase in the consumption tax.

Professor Oguro emphasizes that all these forecasts, while hardly comforting, still have the effect of lulling people into inaction here and now. The greatest danger is further “kicking the can down the road.” Domestic and foreign analysts (notably R. Anton Braun, research economist and policy advisor at the Atlanta Fed) have calculated that the longer the funding gap between social security system expenditures and revenues persists the higher will be the tax rate increase needed to achieve sustainability and prevent collapse.

What is the level of VAT needed to balance system outlays with revenues? If from 2017 the rate would be 33%, to be implemented fully in that year. Delayed another five years to 2022, the rate would have to be 37.5% (Braun).

Can anyone believe that taxes at this level are possible in Japan? Ogura clearly cannot. His main point is that Japan’s political process has revealed its tolerance for taxation, and that tolerance level—maxed out in the near term—simply does not support the (growing) costs of the current social security system.

Ogura’s appeal to politicians is to speak honestly to the voters. That is, to present the issue in terms of which model the people are willing to support: 1. High welfare expenditures/high tax burden; 2. Moderate welfare expenditures/moderate tax burden; 3. Low welfare expenditures/low tax burden. To date the political class has dishonestly offered society a high level of welfare expenditures while demurring from presenting the bill to pay for it; instead, taking the easy, expedient, and politically self-serving way out of issuing debt the burden of which will fall on future generations.

Ogura seems to believe that, presented honestly with a choice, the Japanese people would decide scale down the welfare state, reducing its burden and cost, and, particularly, the weight of its legacy on future generations. The guiding philosophy should be that charity for the needy of any generation should be provided by the same generation, not foisted onto future generations.

Will Ogura’s appeal be heeded? History would suggest not. But at some point what cannot continue must stop. Japan’s welfare state has been built on a foundation of debt, now increasingly held by foreigners. On current trends, that foundation is certain to collapse under its accumulated weight. With its people unwilling to shore up the foundation with huge tax increases (and who can blame them?) there is only one way to avoid disaster: shrink the welfare state.

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Is there any Japanese politicians who were able to foresee what is coming in 3-5 short years ahead? It may sound as if it may be a complicated issue, but what it boils down to is simple arithmetic. What is coming and what is going out should balance out. Both sides of equation should be equal, or you have got a big problem in your hands. Haven’t they realize this is what is coming when they heavily subsidized their small even to big businesses to keep their export oriented business afloat? Japanese borrowed money wrecklessly not realizing this is what is going to happen? Don’t they realize if you spend more than what you make you will eventually go bankrupt? 40% sales tax? It’s just a number that needed to be filled in?

Before repeating this sort of gibberish, it might be a good idea to examine the actual numbers. Or perform a quick thought experiment. The Japanese state constitutes roughtly 40% of GDP. In the EU the state is routinely greater than 50% of GDP. If the size of the state were the issue, why would Japan require higher taxes than Europe? The problem is not high spending. Discretionary spending has been used to underpin the economy only twice in the last 16 years, once in the Asian Financial Crisis and again in the Global Financial Crisis, and in both cases immediately reversed by spending cuts and tax increases. The problem is tax revenues, which have collapsed along with the crummy, deflating, economy -for the cause of which look no further than the BoJ’s repeated tightenings and the MoF’s repeated tax increases/spending cuts. Mr Harner has seen his prescription administered to the patient for the last 16 years. With no positive results – even in terms of a lower deficit.

WISE VISION. Professor Oguro’s thesis was also heavily thanked by Professor MORINOBU Shigeki, Chuo University, and Mr. NAKAMOTO Atsushi, in their paper “Increased Consumption Tax and Intergenerational Equity”, [Policy Research Institute, Ministry of Finance, Japan, Public Policy Review, Vol.8, No4, August 2012]. They present the same actions need although at a slightly lower rate. The problem is politically, the 30% tax requires tremendous cross party and citizen support. The need for massive restructuring is stark and urgent. Not gonna happen!! This reminds me of the Chinese history famous strategist Kung Ming of the 3 Kingdom Saga, “Knowing what cannot be done and still do it.”

DYSFUNCTIONAL POLITICS. For twenty years now, Japan has been caging itself in a Lotus-eater land of too little, too late, too ad hoc, and too short-term devices. In fact compared with most of the OECD countries the taxation level has a lot of room to move. The trouble is the lemmings-like leadership group has not had anyone or group strong enough to consistently take mini-steps in that direction. Now post-haste no one has the stomach to be the Jeremiah calling out the necessary Lamentations and acting on it. Six years and six Prime Ministers; too many cooks. Both parties are too multivariate so no consensus, no momentum. Hashimoto gets his rising support from the negative impetus of voters blaming the two parties, rather than constructive long-vision. It is too much to ask for Japan to suddenly come together and choose a wise leader. Then give him the power to make turnaround steering.

THE FOLLY AND THE HOPE– CHINA TRADE. This is no time to pick a fight, even the smallest fight, with China. The numbers are tremendous. Over the last decade, in spite of the American financial bubble and melt-down, the Lehman Shock, trade with China tripled. If Noda had just stood up to Ishihara so what? Look at the opportunity China presented, and still presents. At US$349B, Japan has a surplus of $49.3B That surplus if increasing at 15% will in 10 years just about triple again. The surplus of $49.3B may disappear to more of a balance but may be maintained because China will grow more than Japan. The cumulative surplus will surpass $1.4 Trillion. By 2020 the total trade annually will be $1.4 to 1.7 Trillion. These are staggering figures. If issues with China are not resolved, there will still be trade but at say still healthy 6% increase, it will be $650B compared to the $1.4-1.7 Trillion level. Any surplus may be halved down from $1.4 Trillion to $700B, half. Tell me can the islands be worth the loss of $700B in cumulative extras or worth less trade of $700B a year? Imagine giving up sovereignty to China in return for cooperative exploration of the potential energy riches. Japan will be able to come out of this ruckus financially unscathed, retaining the China market jewel, and not losing the share of the resources either. There is no way Japan can tap the resources unilaterally. Using stealth or bluster cannot achieve extraction from deep sea; only cooperation can. But the easy thing, to apologize and return the sovereignty to China, may be the most difficult thing to do for small minded politicians. Look at the numbers my suggestions can bring to the financial needs of Japan. They should make any selfless Japanese leader sit up and rush off to Beijing to ease the conflict, by whatever means.

More drivel. Tax revenues are low because tax as a % of GDP is low; tax as a % of GDP is low because profits are non-existent; profits are non-existent because , just as common sense would suggest, after 16 years of deflation there isn’t anything left to tax. The failure is not amongst politicians but at the MoF/BoJ. And then we have the old lie about China. Can anyone offer an example of a rich in GDP per capita terms country getting richer by exporting to a poor in GDP per capita terms country? There is no China dream. It’s a mirage used to offer specious justification to the unjustifiable.

I notice that Mr. Harner did not bother to tell us that “Professor” Oguro was in fact a Ministry of Finance official. Of course, were he pushing a line at odds with the propaganda pumped out by the MoF one might be inclined to take his “analysis” seriously. As it is, it looks more as though Mr. Harner has unwittingly become a MoF stooge.

The short bio provided at the end of the Nikkei piece says that Oguro arrived at his current Hitsobashi teaching post after leaving the MOF. Not clear when he left MOF. In any case, I find strange your insinuation that whatever the MOF might be propounding is prima facie inimical to the interests of Japan and its citizens, much less the cautionary views of Professor Oguro.